INVESTMENTS:

Analysis and Management

Second Canadian Edition

W. Sean Cleary Charles P. Jones

Chapter 8

Portfolio Selection

Learning Objectives
State three steps involved in building a portfolio. Apply the Markowitz efficient portfolio selection model. Describe the effect of risk-free borrowing and lending on the efficient frontier. Separate total risk into systematic and nonsystematic risk.

Portfolio Selection
Diversification is key to optimal risk management Analysis required because of the infinite number of portfolios of risky assets How should investors select the best risky portfolio? How could riskless assets be used?

Building a Portfolio
Step 1: Use the Markowitz portfolio selection model to identify optimal combinations Step 2: Consider borrowing and lending possibilities Step 3: Choose the final portfolio based on your preferences for return relative to risk

Portfolio Theory
Optimal diversification takes into account all available information Assumptions in portfolio theory

A single investment period (one year) Liquid position (no transaction costs) Preferences based only on a portfolios expected return and risk

An Efficient Portfolio
Smallest portfolio risk for a given level of expected return Largest expected return for a given level of portfolio risk From the set of all possible portfolios

Only locate and analyze the subset known as the efficient set

Lowest risk for given level of return

An Efficient Portfolio
All other portfolios in attainable set are dominated by efficient set Global minimum variance portfolio

Smallest risk of the efficient set of portfolios Segment of the minimum variance frontier above the global minimum variance portfolio

Efficient set

Efficient Portfolios

x E(R) A C Risk = y

Efficient frontier or Efficient set (curved line from A to B) Global minimum variance portfolio (represented by point A)

Selecting Optimal Asset Classes

Another way to use the Markowitz model is with asset classes

Allocation of portfolio assets to broad asset categories

Asset class rather than individual security decisions most important for investors

Different asset classes offers various returns and levels of risk

Correlation coefficients may be quite low

Optimal Risky Portfolios

Investor Utility Function
E (R) Efficient Frontier

Borrowing and Lending Possibilities

Risk-free assets

Certain-to-be-earned expected return, zero variance No correlation with risky assets Usually proxied by a Treasury Bill

Amount to be received at maturity is free of default risk, known with certainty

Adding a risk-free asset extends and changes the efficient frontier

Risk-Free Lending
Riskless assets can be combined with any portfolio in the efficient set AB

L
B E(R) Z RF A Risk X T

Z implies lending

Set of portfolios on line RF to T dominates all portfolios below it

Borrowing Possibilities
Investor no longer restricted to own wealth Interest paid on borrowed money

Higher returns sought to cover expense Assume borrowing at RF

Risk will increase as the amount of borrowing increases

Financial leverage

The New Efficient Set

Risk-free investing and borrowing creates a new set of expected return-risk possibilities Addition of risk-free asset results in

A change in the efficient set from an arc to a straight line tangent to the feasible set without the riskless asset Chosen portfolio depends on investors riskreturn preferences

Portfolio Choice
The more conservative the investor, the more that is placed in risk-free lending and the less in borrowing The more aggressive the investor, the less that is placed in risk-free lending and the more in borrowing

Most aggressive investors would use leverage to invest more in portfolio T

Implications of Portfolio Selection

Investors should focus on risk that cannot be managed by diversification Total risk =

Systematic (non-diversifiable) risk

Non-systematic (diversifiable) risk

Systematic risk

Systematic risk

Variability in a securitys total returns directly associated with economy-wide events Common to virtually all securities

Non-Systematic Risk
Non-Systematic Risk

Variability of a securitys total return not related to general market variability Diversification decreases this risk

The relevant risk of an individual stock is its contribution to the riskiness of a welldiversified portfolio

Portfolios rather than individual assets most important

Portfolio Risk and Diversification

p %
35

Total risk
Diversifiable Risk Systematic Risk

20

0
10 20 30 40 ...... 100+

Number of securities in portfolio

Copyright
Copyright 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.